Funds: Death Of An Honor System

What's wrong with this picture? John J. Brennan, chairman of Vanguard, also chairs the boards of all 188 of Vanguard's U.S. mutual funds. Fidelity's chairman, Edward C. Johnson III, chairs the boards of 266 out of 342 Fidelity mutual funds. Reason suggests that no one could possibly execute fiduciary responsibility to mutual-fund shareholders while overseeing this many funds -- and that such insiders could hardly be expected to speak for investors who are their customers.

Yet the industry's trade association, the Investment Company Institute, has so far successfully persuaded Congress not to require independent outsiders for fund boards. Take a compliant Congress, add a trusting Securities & Exchange Commission, toss in a lobbying group, and combine them with lapses in individual ethical behavior, and you have the recipe for a mutual-fund disaster that was waiting to happen.

What is to be done now? Congress should pass legislation mandating outside chairmen. It should reverse the embarrassing exemption it gave to the mutual-fund industry from the Sarbanes-Oxley corporate reform law's requirement that outside auditors evaluate internal controls. The SEC must move to end market timing by demanding fair-value pricing of foreign and small-cap stocks owned by U.S. funds. And it has to impose new rules prohibiting fund companies from accepting orders after 4 p.m. to shut down illegal late trading. The government regulator should also insist that fund company managers reveal their compensation, just as Corporate America does for its top executives. The SEC should also demand that funds provide investors with reports showing fees paid in dollars and cents, not as a vague percentage of assets.

For decades, the mutual-fund industry was allowed to operate without much regulation because it persuaded millions of Americans and Washington that it functioned ethically. We now know that in recent years this was too often a lie. Sadly, honesty must now be imposed on the industry and strictly enforced by the regulators.

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